Louisiana Teachers saves $40 million on transition

BATON ROUGE, La. — The Teachers' Retirement System of Louisiana saved at least $40 million in commission costs when it moved its small-cap and midcap allocation to a core strategy from value and growth.

Using Credit Suisse First Boston LLC, New York, as its transition manager, the $12.7 billion pension system bought $1.3 billion in core small-cap and midcap domestic equities, funding five new managers, and sold $900 million in small-cap and midcap value and growth equities, terminating six managers.

Dan Bryant, Louisiana Teachers' chief investment officer, said the transition, which was mostly completed in one day, cost the system about $20 million.

"Using rough numbers, we saved about a minimum of $40 million," he said. "And the potential loss from market impact over, say, a week could have been $100 million." (Mr. Bryant calculated the savings based on a typical 2.5% round-trip cost to do the trades.)

Richard Kos, an independent plan sponsor and mutual fund adviser who has consulted on transitions worth a combined $7 billion in the last 12 months, said determining how transitions are handled depends on the unique characteristics of each one.

"You're looking at a portfolio of stocks and even though the risk of one stock can be horrific, the risk at the portfolio level is much lower because they're not correlated," he explained. "And to the extent you have both the buy and the sell side of the portfolio, the risk is further reduced and that leaves you with the tracking error.

"At the end of the day, what you're hiring a transition manager to do is manage that tracking error risk as best you can," said Mr. Kos, who was not involved in the Louisiana transaction. "I suspect the $20 million was a good number."

Mr. Bryant explained that while he "pulled the trigger" on the transition on Oct. 11, the process began earlier.

"Six months prior to searching for the new managers, we presented to the board the concept that individually concentrated portfolios of value and growth in the mid- and small-cap area incur way too much risk," he explained. "We demonstrated that we could get a slightly better return and a significant amount of reduction in risk by using a core strategy."

Scott Cooprider, the system's investment consultant at Holbein Associates Inc., Dallas, said many plan sponsors are looking more closely at the level of volatility in their equity portfolios after the bear market declines of 2000-'02.

In the case of Louisiana Teachers, "we were seeing a tremendous volatility that existed in the stylized portfolios of small-cap growth, small-cap value and midcap growth and midcap value," he said. "We were looking for a lower volatility solution and going the core route, given what we analyzed in history, seemed to be the best alternative."

But that still left the problem of the biggest transition in the system's history.

Mr. Bryant said that in the past, when the system terminated a manager or otherwise moved assets, the fund handled it internally.

"We knew this was coming long before we hired the managers and we knew it was going to be a problem," he said. "We trade our own large-cap stocks and if it was a large-cap transition, we'd do it ourselves. Sometimes we've done midcap, but never small cap."

The biggest hurdle in moving from the terminated managers to the new managers was liquidity and trading the positions quickly, he said.

"We had a lot of concerns because of the potential cost," he said.

Without liquidity, the system would likely have paid more for the stocks it was buying and gotten less for the stocks it was selling. Similarly, the longer transitions take, the costlier they become.

"These were very complex asset classes, as challenging as international equities or emerging market equities," said Hari Achuthan, director, portfolio transition management, at CSFB. "It doesn't get any more challenging than this.

"The longer you wait in the market, especially in the SMID (small, midcap) space, your opportunity cost increases," he added. "Our strategy was ‘let's do it as quickly as possible providing best execution, minimizing cost, preventing information leakage and be sure the target managers are funded quickly so performance starts immediately and there's no performance holiday.' "

The new managers are Chicago Equity Partners LLC, Chicago; First Quadrant Corp., Pasadena, Calif.; and Rothschild Asset Management Inc., New York, each with $300 million; and Smith Asset Management Group and Westwood Management Corp., both in Dallas and each with $200 million.

Mr. Bryant declined to name the terminated managers but said the system still has $315 million with Columbus Circle Investors, Stamford., Conn., in a midcap growth portfolio and $260 million in small-cap value equities with Systematic Financial Management LP, Teaneck, N.J.

Mr. Bryant said he did not issue an RFP but instead, working with Mr. Cooprider, did "informal due diligence" on transition managers.

Mr. Cooprider noted that every transition is different and can change depending on what's happening in the financial markets.

"Nobody knows how it's going to work out until you do it," he said. "This was an excellent transition, with very effective cost management. Small- and midcap stocks are typically not cheap to liquidate and initiate."

Mr. Achuthan said even though the equity market was not cooperating in the days leading up to the transition, the firm was handling other small-cap and midcap transitions, which helped provide liquidity for the Louisiana Teachers transition.

"The market was dropping for three to four days (prior to the transition), and if they were raising cash, this fund would have lost a lot of money," he said.